Pegging to Gold and a 100% Gold Standard

In a commentary posted at www.speculative-investor.com on 19th June 2005
we wrote a piece titled "Thoughts on Pegging to Gold and a 100% Gold Standard".
We hadn't intended distributing this discussion as a separate article, but
because Douglas Gnazzo has referred to it in his article at http://www.321gold.com/editorials/gnazzo/gnazzo062105.html we
thought we'd better do so. Otherwise, non-TSI-subscribers would be forced
to rely on Mr Gnazzo's interpretation of what we said as opposed to coming
to their own conclusions.

Interestingly, Mr Gnazzo's above-linked article reads as if it is a rebuttal
of what we said in our 19th June commentary, but in actuality he makes similar
points using different words and emphasis. For example, the main points that
Mr Gnazzo appears to be trying to make are:

1. The (non-100%) gold standard and the gold exchange standard were doomed/designed
to fail, resulting in the reputations of gold and silver becoming unjustly
tarnished

2. Fractional reserve banking is a bad thing. It has, for instance, led
to a 95% loss of purchasing power since 1913.

3. The dollar should be defined as a weight of gold or silver

By way of comparison, the main points we tried to make were:

1. Any half-hearted attempt to make gold part of the monetary system would
be doomed to fail and would lead to gold getting unjustly blamed after the
inevitable breakdown occurred

2. Sound money and fractional reserve banking are incompatible

3. A gold-based monetary system only works if implemented totally; for
example, if there is no fractional reserve banking and the dollar is defined
as a weight of gold

It seems that hard money advocates can't even agree without getting into
an argument.

With all due respect to Mr Kasriel, this is a really bad idea. Gold does,
of course, maintain its purchasing power over VERY long periods of time (50
years or more), but during shorter time periods it experiences enormous swings
in its purchasing power based on worldwide swings in confidence towards financial
assets. For example, gold's purchasing power increased by around 1000% during
the 1970s and then fell by more than 80% between 1980 and 2001. Also, a currency
that was pegged to gold would experience wild swings in its exchange rate over
short periods of time in response to any news that caused the gold price to
spike higher or lower. Imagine, for example, if China's currency had been pegged
to gold in 1999. If this had been the case then the 30% gain in the gold price
that occurred between late-August and early-October of that year in response
to news that European central banks were going to be limiting their gold lending
would have resulted in a sudden 30% increase in the Yuan/US$ exchange rate.
This sort of unpredictable exchange-rate volatility might be a dream come true
for some currency speculators, but it would be a nightmare for export-oriented
businesses and would create huge problems for China's economy.

The enormous volatility in both purchasing power and foreign exchange value
that would result from pegging a currency to gold under the current global
monetary system would be disastrous for any country that attempted it. For
this reason it would make no sense for China to peg the Yuan to gold. And anyway,
China's government, like all other governments, will never be keen to impose
any limits on the amount that it can inflate the money supply. Once obtained,
the power to create unlimited amounts of money is not the sort of thing a government
ever gives up unless it is left with no choice in the matter.

Putting aside the near certainty that today's national governments would fight
'tooth and nail' to prevent the imposition of any rigid constraints on their
ability to inflate, what about the possibility of ALL countries pegging their
currencies to gold at fixed rates? After all, such a system would eliminate
the volatility described above.

Although this would be more workable than any single country pegging its currency
to gold, even this type of gold peg would be a bad idea.

A global monetary system under which all currencies were pegged to gold was
effectively in place for about 25 years following the end of WWII. It was known
as Bretton Woods and it involved having the US$ pegged to gold at a fixed rate
with all other currencies pegged to the US$ at fixed rates. In other words,
all the major currencies were pegged to gold, either directly or indirectly.
This system was a lot more stable than the current system, but it was also
an accident waiting to happen because the peg to gold did not prevent governments
and banks from inflating the supply of dollars and other national currencies
far beyond what would be justified by gold reserves. Eventually the inevitable
happened and the system collapsed during the late-1960s and early-1970s, ushering
in the current fully-floating exchange rate regime and a period of accelerated
inflation.

One of the most important things to realise is that any half-baked attempt
to have an official link between a national currency and gold will be doomed
to fail because sound money and fractional reserve banking are incompatible.
Linking currencies to gold places some limits on the inflationary tendencies
of governments and banks, but what it means in practice is that you get many
years -- decades, perhaps -- of apparent stability followed by a collapse.
Like flood waters breaking through the walls of a defective dam, the inflation
of the currency eventually overwhelms the barrier (the gold peg) that was put
in place to limit the fall in the currency's purchasing power.

From the point of view of the average person the gold standard is by far the
best monetary system ever devised because it involves getting paid for hard
work in terms of something that was produced by the hard work of someone else,
as opposed to getting paid in terms of something that was created at no cost
by a bank. But a gold standard only really works if it is implemented totally*,
that is, if a) national currencies such as the dollar are simply measures of
gold weight in the same way that the metre is a measure of length, b) there
is no central bank, and c) private banks do not have the power to issue more
claims for money than the amount of money they have in their vaults (meaning
that if every person holding a current claim to gold turned up at the bank
on the same day to withdraw their gold they would all be able to do so).

From the point of view of the government and the banking system, however,
a true gold standard would be the worst system imaginable because under such
a system the government would have to remain small and banks would only be
able to grow in the way that normal businesses grow (by operating more efficiently
and/or providing a superior service). As things stand today, the unlimited
ability to inflate provided by the current monetary system has allowed the
US Federal Government to rack up a debt of around 8 trillion dollars and total
liabilities of several times that amount. It has also provided the means for
banks to expand their balance sheets at mind-boggling rates. Total bank credit
in the US, for example, grew at an annualised rate of about 1.3 trillion dollars
during the first quarter of this year.

Many arguments have been put forward as to why a gold standard wouldn't work
in today's world, the most common being that there is no longer enough gold
bullion in the world relative to the size and growth-rate of the global economy.
However, as Frank Shostak explains at http://www.mises.org/story/797 there
can be no such thing as a shortage of money within the framework of a free
market. A shortage of money would be a problem under the current monetary system,
of course, but that's because the current system is a pyramid scheme.

In reality, the only reason we don't have a true gold standard today and are
unlikely to have one in the foreseeable future is the enormous benefits conferred
on governments and banks by the ability, under today's monetary system, to
create unlimited amounts of money out of thin air.

Having said all that, it wouldn't be right to leave this topic without noting
the major benefits of the current system of free-floating irredeemable currencies.
And there are, in fact, two major benefits that we can think of, the first
being that when someone becomes concerned about the on-going inflation they
are free to exchange their dollars (or euros or Yen) for gold, secure in the
knowledge that the gold price will, within a reasonable amount of time, reflect
the effects of the inflation. This ability to use gold as a hedge is an advantage
that the current system has over a quasi gold standard such as the system that
was in place in the US between 1933 and 1971. The second is that because gold
is now completely out of the system there is no chance that it will be blamed
when the eventual collapse occurs. This is potentially important because when
the great credit expansion of the 1920s led to a banking crisis and other major
problems during the 1930s the rigidity of the gold standard, rather than the
excessive expansion of credit (the true cause), was widely touted as being
the main culprit.

*For more information on why the gold standard works well when implemented
in a complete and consistent way, read "The Case for a 100 Percent Gold Dollar" (http://www.mises.org/story/1829)
by Murray Rothbard. By the way, subsequent to the writing of the aforementioned
essay -- the main part of Rothbard's essay was written in 1962 while the
preface was written in 1991 -- the use of gold as the official money has
become even more feasible due to the internet. As services such as goldmoney.com
have demonstrated, the internet provides a very convenient and safe way to
transfer gold between buyers and sellers. No one ever need carry around or
store any physical gold in order to use gold as money, although anyone choosing
to do so would have the ability/freedom to deal in the physical metal.